Finance 407: Multinational

Financial Management
1

TOPIC #6: PURCHASING POWER PARITY

L. GATTIS
THE PENNSYLVANIA STATE UNIVERSITY
 Review
2

Which of the following is most likely a reason for a weak

dollar?
A. Low nominal interest rates and Low Inflation
B. High nominal interest rates and High inflation
C. High nominal interest rates and Low Inflation
D. Low nominal interest rates and High inflation
Which of the following is a likely effect of a weak dollar?
A. Decreased U.S. exports
B. Decreased USD returns to American investments in
foreign assets
C. Inflation
D. Cheaper international travel for U.S. tourists
 Learning Objectives
3

 Learning Objectives
 Students can forecast exchange rates and
expected appreciations using relative and
absolute purchasing power parity
 Definitions
4

 The Law of One Price: Two identical goods must

sell for the same price.
 Why: if there is a difference, arbitragers will buy at the low price and
sell at the high price to exploit the differential. Arbitragers buying
and selling actions will drive prices to equality in equilibrium
 Equilibrium: state of balance or stability
 Arbitrage: the practice of taking advantage of a price difference of an
asset between two or more markets
 Purchasing Power Parity (PPP)
 is The Law of One Price applied to exchange rates.
 states that the equilibrium exchange rate is the ratio of prices of an
identical good in two currencies.
 PPP Example
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 A Coke sells for $2.00 in New York and ₤1.25 in London.
 The PPP theoretical exchange rate is $2.00/₤1.25 = $1.60/₤
 If PPP holds, an American pays $2.00 for a Coke in NY and
₤1.25*($1.60/₤) = $2.00 in London.
 Say the market exchange rate is $1.50/₤. Then the Coke
costs $2.00 in NY and ₤1.25*($1.50/₤) = $1.875 in London.
Arbitragers could buy pounds (sell $) to buy Coke in
London and sell Coke in NY.
 These actions will drive up the price of the pound from the
market price of $ 1.50/₤ to the PPP exchange rate of
$1.60/₤.
 According to PPP, the pound is undervalued (because Coke
is cheaper in London) by 6.25% ((1.5-1.6)/1.6)
 Poll: Concept Check
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 A Big Mac is selling for ¥14.7 in Beijing and $4.07 in

Philadelphia. The market exchange rate is ¥ 6.45/$.
Is the yuan undervalued or overvalued according to
PPP?
A. Undervalued
B. Overvalued
Big Mac
USD: $4.07
CNY: Y14.7

PPP Rate:
Y14.7/$4.07
= Y3.60/$

Market Rate
= Y6.45/$

(3.6-6.45)
/6.45=-44%
 Absolute PPP
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 Absolute PPP states that exchange rates

should be the ratio of prices of identical
goods such as Big Macs
 Why do you suppose Big Macs are cheap in
China?
 “Beefed-Up” Big Mac Index
9

undervalued overvalued

overvalued

undervalued

http://www.economist.com/blogs/dailychart/2011/07/big-mac-index
 Absolute PPP: Price Index
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 A more reasonable application of PPP is to

use a price of a basket of goods
 Example: A basket of widely available goods cost
¥1,000 in Tokyo and $12 in Washington.
 The PPP Rate = ¥1,000/$12 = ¥83.33
 If the Market Rate is ¥80
 The dollar is undervalued
 the yen is overvalued
 Relative PPP
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 Relative PPP allows differences in the absolute

prices of goods due to supply and demand
factors.
 Relative PPP predicts that changes in price levels
(i.e., inflation) will affect exchange rates
 Specifically, relative PPP states that a country’s
currency will devalue if it has higher inflation
 Relative PPP Formula:
e0=current spot rate of currency f in terms of h
t
 1  ih  et=expected spot rate at time, t

e  
h/f h/f ih= Inflation rate from time 0-t in country h
e
1 i 
if= Inflation rate from time 0-t in country f
t 0
 
E.g., Euro will appreciated if $ inflation higher
f $1.2238/€ = $1.20/€*(1.03/1.01)
Where h=$ and f=€, i$=3%, i€=1%, t=1 year
 Relative PPP Formulas
12
 The euro will appreciate by approximately the
interest rate differential (3%-1%=2%) in one year
t

h/f  1  ih
 $/ 1
h/f
e  e0  e  1.20 1.03   1.2238
t 1 i  1  1.01 
 f 
 The euro will appreciate by approximately the
interest rate differential x 2*2% (4%) in two years
t

h/f  1  ih
 $/ 2
e h/f
 e0  e  1.20 1.03   1.2480
t 1 i  2  1.01 
 f 
 Relative PPP Formulas: < 1 year
13
 Relative PPP formula for n months

 12
1  ih n
1  i n 
eh/f
n eh/f
0
f12
 The euro will appreciate by approximately the
interest rate differential x ½*2% (1%) in six months

e.$/5

1  .03 6
12
  1  .015 
1  .016 
 1.2  1.2   1.2119
 1  .005 
12
 Poll
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 Suppose that CAD inflation is 5% and U.S. inflation is 1%. The spot rate is C$1.02/$.
Which Currency will appreciate?
A. CAD
B. USD
What is the expected spot rate in
I. 1 year?
A. C$.9811
B. C$1.0604

II. 2 years?
A. C$.94378
B. C$1.1024

III. 9 months?
A. C$.9905
B. C$1.0504
C. C$.98114
D. C$1.0604
 Relative PPP
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t
 Rearranging terms h/f
e  1  ih 
t
 
h/f
e 1 i 
0  f 
 The LHS of the equation is (1+the expected
appreciation) of currency f
 Suppose U.S. inflation is 3% and Mexican
inflation is 12%. What is the expected
appreciation of the peso in one year?
A. 8.7% B. 8.04% C. -8.7% D. -8.04%
 Poll
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 Suppose the spot price of the HKD is HK$7.75/USD

and the one year spot forecast is HKD7.89. U.S.
inflation forecast is 3%.
 What is the expected appreciation of the HKD?
 Is inflation lower or higher than 3% in Hong Kong?
 What is expected HKD inflation according to PPP?
A. 4.86%
B. -4.86%
C. 1.2%
D. -1.2%
 e1h/f 1  ih
Assigned Problems e0h/f

1 if
17
1. The South African rand is selling at a 5% discount for one year delivery. U.S. inflation
is 3%. What is South African inflation according to relative PPP?
From PPP; f1,($/R)/e0($/R)=1+Premium=(1+i$)/(1+iR); 1+(-.05) =.95 = 1.03/(1+iR); i = 8.4211%
2. The two-year forward kroner is selling at 9% above the spot price. If inflation in the
U.S. is 6% per year, what is the expected Danish inflation?
f1,($/Kr)/e0($/Kr)=1+Premium=(1+i$)/(1+iKr); 1.09=(1.06/(1+iKr))^2; 1.09^.5=1.06/(1+iKr); iKr = 1.5296%
3. A latte costs £5.35 in London and $4.35 in New York. The actual pound exchange rate
is 1.50 pounds per dollar. According to purchasing power parity, how much is the $
overvalued or undervalued?
PPP = 5.35/4.35 = £1.23/$; Actual = £1.5; Act. price of $ too high; $ is overvalued by (1.5-1.23)/1.23=22%
4. Suppose a Big Mac cost $2.43 in New York and Yuan9.90 in China. According to the
absolute version of Purchasing Power Parity (PPP), how much is the yuan overvalued
or undervalued if the spot Yuan/$ exchange rate is 8.11?
PPP = 9.9/2.43 = 4.074, Act = 8.11; $ overvalued, Yuan undervalued; Yuan undervalued by (4.074-8.11)/8.11=-49.8%
5. The U.S. price index increased from 110 to 120. Over the same time, the Japanese
price increased from 105 to 106. What should have been the appreciation of the yen?
Hine compute the US and yen inflation (% changes in price indexes) and use in PPP
formula.
i$=(120-110)/110=9.091%; i¥ = (106-105)/105=.9524%; Yen Appr. = (1+i$/(1+i ¥)-1=(1.09091/1.009524)-1=8.06%
 e1h/f 1  ih
Assigned Problems e0h/f

1 if
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6. Inflation in the U.S. and Japan is 3% and 1%, respectively. What is the expected
appreciation of the Yen in one year?
= Guesstimate: Yen will appreciate by 2% because it has lower inflation
= PPP: 1 + Apprec iation of Yen = (1+i$)/(1+i¥)
= Appreciation of the yen = (1+i$)/(1+i¥) – 1 = 1.03/1.01-1= 1.98%

7. Inflation in the U.S. and Australia is 3% and 2%, respectively. The spot price of the
aussie is $1.15. What is the expected spot price of the aussie in one year, two-years,
and six-months?
= 1-year =1.15*(1.03/1.02)=$1.1613
= 2-year =1.15*(1.03/1.02)^2=$1.1727
= 6-months = $1.15*(1.015/1.01)=$1.1557
 Textbook
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 Shapiro and Sarin’s Foundation of Multinational

Finance 6th Ed.
 Chapter 4 covers purchasing power parity, interest
rate parity, unbiased forward rate, and currency
forecasting
 iClicker: Class Evaluation
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A. Highest
B.
C.
D.
E. Lowest